COST OF CAPITAL

Businesses acquire funds from market in various forms. These generally include Equity shares, preference share, debentures and long-term loans. The company after acquiring funds from investors, invests those funds in various projects. The investor who contributes funds in any form expects some returns on their contribution. The company must earn a certain rate of return that satisfies their investors expectation. Thus, in simple terms, cost of capital is the value which has to be paid to investors for availing and using capital from them. In this sense, the company must earn a rate of return at least equal to that an investor expects.

Definition

According to Milton H. Spencer: “Cost of Capital is the minimum rate pf return which a firm requires as a condition for taking investment”.

According to Solomon Ezra: “Cost of capital is the minimum required rate of earning or the cut-off rate for capital expenditure”.

Measurement of cost of capital involves

1. Measurement of specific cost
2. Computation of combined cost/composite cost/weighted average cost.

Measurement of specific cost includes costs from major sources such as:

1. Cost of Debt (K_d)
2. Cost of Equity (K_e)
3. Cost of Preference (K_p)
4. Cost of Retained Earnings (K_r)